The U.K. Financial Conduct Authority has confirmed most USD Libor rates will be published through June 30, 2023, paving a clear path to eliminate LIBOR risk for most credit union investments.
Originally utilized in 1969, LIBOR—the London Interbank Offered Rate—was officially adopted by the British Bankers Association in 1986 as a benchmark rate and has subsequently become the global standard for the rate at which banks lend to one another. LIBOR rates are set by banks daily, with each bank providing the estimated rate at which it expects to borrow funds at a series of maturities (as well as a variety of currencies, which has led to Euro and Yen LIBORs, among others).
The presence of such a robust interest-rate setting process led market participants to adopt LIBOR rates as the basis for a wide variety of financial products. Recent estimates place LIBOR as the reference rate in over $200 trillion of active financial contracts in the cash and derivatives markets. LIBOR exposure can most commonly be found in the investment portfolios of banks and credit unions in the form of variable rate mortgage-backed securities and collateralized mortgage obligations.
In our previous articles we discussed the differences between the two benchmarks and the challenges to a smooth transition. In 2020, Fannie Mae, Freddie Mac, and Ginnie Mae each released superseding fallback language for outstanding securities ensuring a smooth transition into the post-LIBOR era. This complimented previous fallback language that was implemented into prospectuses for new securities issued over the last few years. The fallback language has eliminated the risk of legacy GSE floating-rate MBS and CMOs becoming fixed-rate securities in the absence of a LIBOR rate.
This March, the U.K.’s Financial Conduct Authority confirmed that most LIBOR rates are set to expire at the end of 2021, but most U.S. Dollar denominated rates will be extended by 18 months through June 2023. USD LIBOR rates that are now set to expire at the end of June 2023 include overnight, 1-month, 3-month, 6-month, and 12-month tenors. 1-week and 2-month USD LIBOR rates will no longer by published as of December 31, 221.
With the LIBOR end date in sight, adoption of SOFR in the U.S. should accelerate in the coming months and regulators remain adamant that USD LIBOR should not be used for new contracts after 2021.
To further facilitate the LIBOR transition, the International Swaps and Derivatives Association (ISDA) announced that March 5, 2021 is the “Spread Adjustment Fixing Date” for all LIBOR tenors. Consequently, all fallback rate calculations for LIBOR will use the spread calculations effective on this date when determining the LIBOR to SOFR spread adjustment at LIBOR cessation.
These adjustments are necessary because unlike LIBOR, SOFR does not contain an element of credit risk imbedded in its rate structure due to the collateralized nature of the underlying transactions contributing to this rate. Listed below are the static spread adjustments over SOFR for each respective tenor.
Due to differences in underlying data and calculation methodologies, it is not expected that the SOFR fallback rates will identically match the LIBOR rate that it replaces. As a reminder, SOFR is inherently backward-looking and compounds historical overnight rates when calculating the various tenor rates, while LIBOR term rates are forward-looking. It is possible that these differences between the two rates may result in mark-to-market adjustments on the securities exposed at the LIBOR cessation date. In theory, the securities subject to LIBOR cessation will converge to the post-LIBOR reset rates in order to reduce arbitrage opportunities.
While there will still be more bumps along the way, actions by the government-sponsored enterprises and regulatory bodies over the last year have dramatically reduced LIBOR transition risks for credit union investors. The NCUA will continue to assess LIBOR transition risk during annual examinations and credit unions are encouraged to assess ongoing LIBOR exposure as we approach the USD LIBOR cessation date on June 30, 2023.
If you would like to discuss further or learn more about this topic, please reach out directly to your Accolade investment adviser representative.
By JD Pisula